Investments like stocks and bonds have the advantage of being liquid, meaning investors can buy and sell these assets quickly in order to have access to capital.
Real estate, on the other hand, is considered an illiquid investment, meaning money invested in this asset class is usually tied up for a considerable period of time. The sector is also characterized as illiquid due to its predominantly private nature, the prolonged length of time and amount of effort usually needed to complete transactions, and the decreased access to capital for these transactions.
While illiquidity may sound like a negative, real estate investments have historically generated up to 5% higher returns over time periods ranging from 10 to 25 years than public equities have. Those higher returns are referred to as the illiquidity premium.
There is some discrepancy in real estate circles as to whether the illiquidity premium really exists. In other words, do the increased returns outweigh the added costs of real estate investment, including the required seasoned expertise in a particular product type and increased governance costs?
The fact is, there are many advantages to real estate investments that compensate for the lack of liquidity. For one, unlike fungible stocks and bonds, real estate allows investors to enhance the actual properties in which they invest through redevelopment or conversions. Yes, this does increase the amount of capital invested in the property, but it also increases the returns—and when executed correctly, has the potential to increase them exponentially.
Also, investing in real estate provides investors with the opportunity to learn about different geographical markets and the asset classes within them and how the markets react to various tailwinds and headwinds on a more granular level than most liquid investments do. These lessons help shape future investment transactions for better returns and help mitigate risks in those investments. Rather than just following the ups and downs of the market, investors are better informed about the nuances of the industry and may even be helping to shape them.
In fact, investing in real estate can have a lasting social impact on the markets and communities in which investment properties are located. The new federal Opportunity Zone legislation is designed to encourage long-term (i.e., illiquid) investment in areas of the country that are in need of revitalization and offers investors a reduction in—and eventual elimination of—capital gains taxes on those investments. While the IRS has imposed rules and restrictions on claiming these benefits, this legislation is a real breakthrough for impact investors.
Illiquid investments like real estate also help investors safeguard their portfolios by providing diversification from public markets and downturn protection, since private investments are slower to respond to valuation shifts than public investments like stocks and bonds are.
While downsides to real estate investment’s illiquidity do exist, there are clearly many positives for real estate investors. From greater control to portfolio diversification and risk mitigation, the illiquidity premium can be a valuable tool in investors’ wealth management toolbox.
Related: Commercial vs Residential Real Estate Investing